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Learn about Discounted Gift Trusts and understand what role they play in inheritance tax planning.
A Discounted Gift Trust is a trust based inheritance tax planning arrangement for those individuals who wish to undertake inheritance tax planning but who are unable to lose full access to their investment.
The term "discounted" is used because the value transferred on establishing the trust is less than the amount invested.
There are two basic types of Discounted Gift Trust, but many variations on the general theme.
Nil or negligible discount is available where the settlor is, or is "rated" over 90. The value transferred in such cases is the policy premium.
The courts have previously considered discounted gift trusts.
What is a Discounted Gift Trust?
A Discounted Gift Trust (DGT) is a trust-based inheritance tax (IHT) planning arrangement for those individuals who wish to undertake IHT planning but who are unable to lose full access to their investment. In a DGT, access is typically provided by means of a series of preset capital payments to the investor who will be the settlor of the trust.
DGTs take many forms.
Why is the term ‘discounted’ used?
The term ‘discounted’ is used because the value transferred on establishing the trust is less than the amount invested. This is the logical consequence of the fact that the settlor is entitled to a stream of capital payments. The settlor is typically entitled to payments on specified dates subject only to be alive on those dates. The settlor's transfer or gift is the bond/policy premium less the value of the payments receivable during his/her lifetime.
What is the nature of the payments received from the trustees?
Payments from the trustees to the settlor in a DGT are capital, not income.
How is a DGT structured?
There are two basic types of DGT but many variations on the general DGT theme.
Those based on a bare/absolute trust structure and those based on a discretionary trust structure.
Use of a bare/absolute trust structure triggers an IHT potentially exempt transfer (PET) by the donor. The trust fund is within the beneficiary's IHT estate. (In this context the trust fund is the policy/bond value less the value of the settlor's rights to payment.)
Use of a discretionary trust structure triggers an IHT chargeable lifetime transfer (CLT) by the settlor and the trustees are thereafter within the relevant property regime. The discretionary structure gives greater flexibility.
Joint settlor versions of both structures are widely available.
Chargeable event gain issues
In a bare/absolute structure, where a chargeable event gain arises in the tax year following that in which the donor dies, the gain is chargeable under section 465(2) ITTOIA 2005, i.e. on the individual who owns the rights under the policy. That individual will be the named beneficiary.
For chargeable events arising during the donor’s lifetime or in the year of the donor’s death, HMRC advised us in an email dated 6 August 2019 that its view is as follows:
Both donor and beneficiary have a material interest in rights (of a different kind) under S470(2)(a) and (b) and so gains are attributed in accordance with their share of the rights on a just and reasonable basis under s471(7)
Donor is alive and regular withdrawals breach 5% allowance.
Regular withdrawals are considered part surrender of rights under s500(a) ITTOIA 2005. S498 directs us to perform the calculation under s507 to determine if a gain has arisen as a result of this part surrender. If a gain has arisen, it has arisen because of the regular withdrawals (and only the donor holds the right to such withdrawals) and any gain will be assessable on the donor as a result - it would be just and reasonable to apply this treatment.
Donor is alive, regular withdrawals do not breach 5% limits but a chargeable event gain arises as a result of the trustees making an ‘emergency’ advancement of trust capital to a named beneficiary (without reducing the value of the donor’s rights).
The gain in this case is the falling due of a sum payable as a result of a right (and continuing right) under the policy (500(a)). This is a right held by the beneficiary only, and so they will be assessable on the gain on a just and reasonable basis (s469 ITTOIA05).
Donor dies and is the sole life assured (or donor dies and bond is encashed in that the tax year of death).
If the donor’s only right is the right to regular withdrawals, and this right is terminated on death then it is reasonable to assume that any gain arising after the date of death is likely to be considered a transfer of income/capital to the beneficiary only. Unless a regular withdrawal was made before death, or to the estate after death, then it would be reasonable to assume the gain would be wholly attributable to the beneficiary.
In a discretionary trust structure, chargeable event gains arising on the trustees' bond/policy will be assessed on the settlor whilst alive and UK resident and thereafter, in tax years after death, on UK trustees.
Advantages and disadvantages of DGTs
allow an IHT-effective transfer
allow settlor access through preselected payment stream
may attract a discount
tried and tested – ‘work as described’
payment stream can't be changed
payments generally capped so as not to exceed the 5% rule
There’s considerable HMRC comment on the valuation of the ‘transfer’.
It is generally acknowledged (based on comments in the Bower case) that HMRC accepts that DGTs work as intended.
Reservation of benefit
DGTs don’t trigger the reservation of benefit provisions because the settlor's rights are never given away. The settlor's gift to the trustees is subject to the pre-selected payment stream, the right to which is never given away.
Would the settlor's payment stream have a value on his/her death?
The settlor's contingent right (contingent on his/her survival to the selected date) will have no value on death. There is nothing to be included in his/her estate in respect of the payments. Although the deceased is treated as making a transfer of value the instant before death, the value actually transferred takes account of the fact that he/she has died. So the value of the payment stream on death is nil.
The starting point is to estimate the settlor's life expectancy. This is done through an underwriting process. Once the settlor's life expectancy has been established the value of the payments receivable during his/her lifetime is calculated and reduced to current values by use of a discount factor (a reverse interest rate). An adjustment is made for various costs. The value of the settlor's entitlement is deducted from the premium to give the value transferred.
Nil or negligible discount is available where the settlor is, or is ‘rated’ over 90. The value transferred in such cases is broadly the policy premium.
The value transferred – the view of the courts
The case of HMRC v Bower (Executors of Estate of ME Bower) 2008 EWHC 3105 (Ch)
Another success for HMRC. The case concerned Mrs Kathleen Watkins who died on 18 March 2006 aged 91 years and one day. On 21 December 2004 (when aged 89 years and nine months) she established a DGT where there were specified level payments of 10% p.a. of the single premium for the trust property (the Skandia bond), payable quarterly for the life of the settlor. This was quantified at £4,250 per quarter, or £53,273 over the actuarially reckoned life expectancy of Mrs Watkins of 3.1337 years. A medical report on Mrs Watkins dated 20 October 2004 was taken into account in the actuarial projection. The value of her interest (i.e. the "discount") was assessed as £52,273. The HMRC view was that the appropriate discount was £4,250 (i.e. one quarter's payment).
Pre-owned asset tax (POAT)
The operation of a DGT should not trigger an income tax charge under the POAT regime.
Disclosure of Tax Avoidance Schemes (DOTAS) regulations were introduced way back in 2004 to provide early information to HMRC about schemes containing defined ‘hallmarks’ of tax avoidance. IHT was first brought into DOTAS in April 2011 but only in very limited circumstances. The Government widened the hallmark with new regulations effective from 1 April 2018. The aim is to catch IHT avoidance schemes but not ‘bread and butter’ IHT planning. In short, established IHT planning schemes (e.g. a DGT) whose workings are well understood and agreed are in the clear where
The scheme was sold and implemented at least once before 1 April 2018
HMRC has indicated its acceptance it achieves that well understood tax outcome, and
It is sold and implemented without being changed after 1 April 2018
On 7 November 2018, HMRC issued a consultation document “The Taxation of Trusts: A review”. In simple terms, the consultation sets out the government’s thinking on making trusts fairer, simpler and more transparent. At the time of writing, the government is notmaking specific proposals for reform.Instead, the government will weigh up the views and evidence presented and consider the options for targeted reforms.
On 23 November 2018, the Office of Tax Simplification published its First Report regarding its review of the IHT regime. This concluded that too many people have to fill in IHT forms, with the process being complex and old fashioned. The recommendations therefore relate to administrative issues. The second report covering wider areas of concern (technical and design issues) was published in July 2019. This included a recommendation that the ‘seven year clock’ should become a five year clock.